Protecting Your Business With a Self-Insured Retention

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Image courtesy of [Anthony Bradshaw] / Getty Images.

One self-insurance mechanism used by some businesses is a self-insured retention. A self-insured retention (SIR) can be used in conjunction with a general liability, auto liability, or workers compensation policy. It can be an effective way to save money on insurance premiums. This article will explain how it works.

Risk Retention

A business chooses a self-insured retention because it has opted to retain some risk.

The business decides the amount of risk, in monetary terms, and the types of risks it wants to retain. It then creates a fund to pay losses that result from those risks. Here is an example.

The Idyllic Inn is a large hotel located in an area frequented by tourists. The hotel typically incurs several liability claims each year. Many are filed by guests who have sustained injuries in slip-and-fall accidents. Most claims have been small, but the hotel has incurred a few that exceeded $50,000. 

The Idyllic Inn is insured under a general liability policy that has a $1 million Each Occurrence limit. The hotel has elected to retain some losses in order to reduce the cost of its liability insurance. Thus, Idyllic's liability policy includes a $100,000 self-insured retention. The firm has established a fund to pay liability claims. If a claim occurs, the hotel must pay damages up to the $100,000 retention amount.

If the damages exceed $100,000, Idyllic's liability insurer will pay the remaining amount, up to the $1 million policy limit.

A self-insured retention can be an important part of an employer's risk management plan. However, it is typically available only to mid-sized or large employers. Small employers don't have the financial capacity to pay large losses out of pocket.

State Laws

Some states limit the use of a self-insured retention as a replacement for certain types of insurance. Many states prohibit businesses from using a SIR in place of auto liability insurance unless they meet certain requirements. For instance, a SIR may be permitted only if a business owns a specified number of autos (such as 25). The business may be required to provide evidence of financial security, such as cash or a certificate of deposit. It may also be required to purchase excess auto liability insurance.

Many, but not all, states permit employers to self-insure a portion of their workers compensation obligation via a deductible or SIR. To utilize self-insurance, an employer may be obligated to obtain a self-insurance certificate from the state workers compensation authority. It may also be required to purchase excess workers compensation insurance. The excess insurer will demand evidence of financial security, such as a surety bond or letter of credit. A letter of credit is issued by a bank. It ensures that funds the employer has deposited will be available to pay claims, even if the employer becomes bankrupt.

How It Works

Here's how a self-insured retention typically works:

First, you evaluate your firm's liability risks and determine the maximum amount it can sustain for a single loss. This amount will become your SIR. For example, you decide that your firm can handle any loss that doesn't exceed $1 million. Your SIR is $1 million. If your company sustains $870,000 loss, your firm will pay the entire amount and your insurer will pay nothing. Your insurer has no obligation to pay since the loss did not exceed your SIR.

Next, your business creates a fund to pay all losses that are less than the SIR. Your fund must be adequate to absorb all claims you accumulate during the policy period. You must estimate the maximum amount of losses you expect to incur during that period. Note that your accumulated losses could exceed the amount of your SIR. For instance, suppose you sustain two losses, one for $800,000 and one for $400,000.

Neither loss exceeds your SIR, but together they amount to $1.2. If you have set aside only $1 million to pay for losses, you will be $200,000 short.

The third step is to create and maintain a loss payment fund as required by law. Your funds should be held in an interest-bearing account. Some self-insured retentions include damages only. Others include both damages and claims expenses. If your SIR includes claims expenses, you may be responsible for adjusting claims that fall within the SIR. You can hire a third-party administrator to perform this function. Alternatively, your insurer may adjust claims and bill you for the claims expenses.

A SIR may be subject to a Per Claim limit or an Each Occurrence limit. An annual aggregate limit may also apply. An aggregate limit protects your business if it incurs numerous claims during the policy period that are less than the SIR.

Finally, you may be obligated by law to purchase an excess policy. As noted above, excess coverage may be required if you have self-insured your auto liability or workers compensation obligation.

Benefits of a SIR

A SIR offers several benefits. First, it can provide significant savings on insurance premiums. Another advantage is greater control over the claims adjustment process. When a claim falls within the SIR, you can decide whether to settle it or contest it in court. Thirdly, you will have an incentive to control losses since you will be paying many of them using your own funds. Fourthly, your cash flow may improve. You'll pay losses as they occur rather than paying for them in advance via insurance premiums. 

Article edited by Marianne Bonner